Ray Dalio says he buys this nasty narrative about China that's starting to get play again

REUTERS/Chance Chan
Wall Street is talking about China as if it has a disease — deflation — and is about to pass it to the rest of the world.

It's an issue that comes up with China from time to time, and it has two parts.

As China's economy goes through the painful transition from an investment-based economy to one based on consumer spending, its demand for materials — especially commodities — that it once consumed in great volume will decrease, suppressing prices and hurting commodity sellers.

Also, to smooth out the transition China will allow its currency to decline so it can sell more goods abroad and solve its problems with overcapacity. This, in turn, could spark other countries to do the same thing.

But things have changed since then, especially now that the country is allowing its currency to depreciate in a controlled manner.

Suddenly all of Wall Street is either rallying to China's defense or accusing the country of poisoning the global well. Suddenly this "exporting deflation" theory isn't being relegated to known bears and bubble-watchers — it's dominating a conversation.

Billionaire hedge fund manager Ray Dalio mentioned it during the World Economic Forum at Davos on Wednesday.

"I think the Chinese situation with the currency is very important. Very important. If there is significant currency weakness for the Yuan that will mean more imported deflation and it will make things more difficult."

This weekend, Deutsche Bank economist Torsten Slok, a China bull, addressed the accusation directly in a note called "Is China Exporting Deflation?" First off, he reminded his readers that a China slowdown would do little to US or European gross domestic product.

He also said concerns about this were overblown because the volatility this year — a few Chinese stock market crashes and a currency devaluation — doesn't translate into the real economy.

"The currency move is probably not a precursor to a major devaluation and there are signs of improvement in the residential property market," Slok wrote. "Indeed, our outlook for Chinese growth is unchanged at 7% for this year."

(The country's GDP growth came in at 6.9% for 2015 — a figure many on Wall Street question.)

So nothing to see here, right?

A lot of economists would dispute that. Why? Because China's effect on the US and Europe aside, where Slok says the yuan's downward move isn't the beginning of anything major, others disagree strongly.

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In play

That is because since the beginning of the year the yuan has become one big question mark.

Celebrated China analyst Charlene Chu wrote earlier this year that, as the Chinese government runs out of good options to stimulate the economy, the yuan is now part of its "playbook."

"In our view, a much larger move [in the yuan] than 2015's 4.6% is likely over 2016-17, the size and timing of which will be driven by the degree of capital outflows and extent of deceleration in GDP growth," Chu wrote.

Combine that with what Oxford associate professor George Magnus has said about what a declining yuan is already doing to the world. Emerging and developing markets, which make up 40% of global GDP, are already hurting thanks to China's slowdown. A cheap yuan would only make that worse.

"A Yuan devaluation would almost certainly be reflected in further across-the-board US dollar appreciation bringing new financial stress to both commodity producers, and to non-financial companies that have borrowed in US dollars," Magmus wrote in Prospect Magazine earlier this month. "Both topics have figured prominently on the IMF's financial instability watch-list for some time."

In other words, a falling yuan sets off the second deflationary trigger as the world starts to handle Chinese overcapacity.